EU ETS Reform & the Carbon-Trading Renaissance

On February 6th, the European Parliament finally approved an overhaul of the European emissions trading system (ETS) which will become effective by 2019. The reform will introduce a new mechanism to raise the price of carbon, the Market Stability Reserve (MSR). The MSR will absorb excess allowances to avoid market saturation already at the end of phase three of the EU ETS. It will also set the rules for the fourth phase of the EU ETS, starting in 2021, by adjusting the free allowances allocation rules to avoid excessive supply in the future. Market analysts are confident that the reform will push the cost of allowances and provide an incentive for industries to adopt cleaner technologies.

Why the change and who does this impact?

As part of the Paris Agreement, the EU committed to the agreed upon target necessary to limit global warming well below 2°C. Accounting for around 45% of Europe’s GHG emissions, and covering more than 11,000 installations, the ETS is one of the EU’s key policies aimed at achieving the Paris commitment.

The EU ETS started twelve years ago, and it is now in its third phase. The policy involves a market-based cap and trade system which requires companies to buy allowances to cover their carbon dioxide, nitrous oxide and perfluorocarbons emissions. By 2016, EU ETS installations had already reduced their emissions by 26% compared to 2005. However, further progress is needed; given the fact that the EU expected 43% emissions reductions from sectors covered by EU ETS by 2030, a substantial gap has already grown since this 26% achievement.

Europe’s economic slowdown after 2008, combined with an initial over-allocation of free allowances dragging on from phase one, drove the price of allowances down. Towards the end of 2016, the price of carbon allowances fell below €5 per ton—far less than the envisioned €30 per ton. Consequently, businesses had little incentive to reduce their emissions, which was the intention of the whole scheme. A reform of the EU ETS became necessary to ensure a well-functioning system that allows the European Union to meet its 2030 objectives and beyond.

Top 4 Changes

The total number of emission allowances (cap) will decline at a faster pace than before: by 2.2% annually instead of 1.74%

A MSR will hold excess allowances outside the market beginning in 2019

Benchmark levels defining the amount of free allowances an installation can claim will be corrected based on the 10% most efficient installations’ performance by sector

Carbon leakage sectors inclusion rules will be revised to target the most at-risk sectors

The recent agreement to reform the ETS comes after years of discussions and concerns about the purpose of the scheme. The new regime hopes to deliver greater cuts in greenhouse gases while providing protection for energy-intensive industries. The list of these so-called carbon leakage segments (e.g. mining, metals or energy-intensive manufacturing) is still valid, with initial revisions for the period taking place after 2020. Within the scheme, two new funds of up to €12bn (£10.2bn) will be established to help the industry innovate and invest in technology. The ‘Innovation Fund’ will extend existing support for the demonstration of leading-edge technologies to breakthrough innovation in industry. The ‘Modernization Fund’ will facilitate investments in modernizing the power sector and wider energy systems, as well as boosting energy efficiency in 10 lower-income Member States.

Expert Perspective from Frédéric Pinglot, Sustainability Consultant

“EU allowance prices reached an unprecedented 6-year high of €13 per ton in March 2018. With the introduction of the MSR and greater quotas demand from the sectors, prices are expected to rise towards €30 per ton in 2023.

There will be winners, and there will be losers from this change. The best performing installations will receive more allowances for free than they will emit carbon, turning the scheme into a great opportunity to create extra revenue. Installations that did not invest in efficiency or renewable energies early enough will see their EU ETS costs skyrocket from increasing prices and reduced free allocation.

Because the scheme will only become more restrictive in time, investments should be made now to capitalize on future improvements and reduced carbon costs. When assessing a project’s feasibility, it is critical to understand the impact on carbon emissions and subsequent quota costs, and to include these factors to build a business case. In fact, this should be done not only for EU ETS installations, but also across the portfolio as recommended by the Task-Force on Climate Related Financial Disclosure using an internal carbon price to better tackle climate-related risks and capture opportunities.”

Reform is part of a broader global trend

In their 2°C mitigation scenario, the International Panel on Climate Change (IPCC) assumed rapidly growing carbon prices would be needed to drive the global low-carbon transition: about €64.5 /tCO2 by 2030, €129 /tCO2 by 2050. According to the most recent publication by International Energy Agency (IEA), global energy-related CO2 emissions grew by 1.4% in 2017 reaching a new historic high after three years of global emissions remaining flat. This proves that more radical and rapid measures are required to achieve the below 2°C goal.

Source: International Energy Agency

The EU ETS reform is thus part of a global “carbon-trading-renaissance”. In December 2017, China launched a national emissions trading system that will initially cover only the power sector, but will expand over time. Given the size of China’s power sector, this system will already be larger than the entire EU ETS. China’s announcement followed other declarations during the One Planet Summit in Paris in the same month. Leaders from several countries across the Americas—including Canada, Colombia, Chile and Mexico, as well as the U.S. states of California and Washington—launched the Carbon Pricing in the Americas cooperative framework, with an eye to eventually link their emissions trading schemes. Forty-two national and twenty-five sub-national jurisdictions are now putting a price on carbon emissions across the world.